This article first appeared in Forum, The Edge Malaysia Weekly on July 20, 2026 - July 26, 2026

The world, it appears, has developing countries, developed countries and then there is Japan. A nation whose central bank, the Bank of Japan (BoJ), has over several decades taken a policy path that can only be described as “unorthodox”. Ironically, these unorthodox policies not only were ineffective but also contributed to Japan’s “lost decades”, a period close to 30 years from 1990 of stagnation and deflation. The yen’s current problem, its depreciation to 40-year lows against the US dollar, is simply the aftereffects of the policy reversal and normalisation that began in 2024. Japan’s post-war growth, spectacular by any measure, brought it all the way from being a nation devastated by war to being the world’s then second largest economy. The nearly four decades of hypergrowth ended in 1990 with the bursting of its real estate and stock market bubble. The seeds leading to the asset bubble bursting, however, were planted in New York at the Plaza Accord of 1985. The Plaza Accord was a currency arrangement by the G5 countries, forcing Japan to revalue the yen against the US dollar. Their allegation being that Japan had maintained a “dirty float”, enabling it to take unfair advantage of an undervalued currency. As a result, the yen, which was at approximately 260 against the dollar at the time of the accord, appreciated sharply to 128 per dollar, an appreciation in excess of 100%, in a little more than a year. That appreciation continued unabated until the yen hit 84 against the dollar at end-1995. In attempting to provide some friction against the yen’s steady rise, the BoJ undertook a series of aggressive interest rate cuts. Japanese interest rates, already low given the high domestic savings rate, were cut aggressively. The initial result was a worsening of the asset bubble which burst in 1990, throwing the country into a sharp recession.

It was in response to this downturn that the BoJ pioneered several unorthodox policies. As growth slumped, more of the same rate cuts were pursued. The BoJ’s policy rate went from 6% in 1990 to 0% in 2001, with the shorter-term, three-month rate going into negative territory and remaining there for several years. The BoJ was one of the world’s first central banks to experiment with zero and negative interest rates. The aim was to discourage savings, stimulate domestic consumption and thereby overcome disinflation. A second set of unorthodox policies was the pioneering of what has subsequently come to be known as quantitative easing (QE) in March 2001. QE involved creating new electronic money to purchase government bonds and other securities from financial institutions. The impact of QE, like the more traditional open market operation, increases liquidity and thereby reduces yields/interest rates.

As if reducing interest rates through QE wasn’t enough, the BoJ introduced its most controversial policy of yield curve control (YCC) in 2016. A new form of interest rate repression, YCC was used to keep the short end of the yield curve at zero while keeping the long end, the 10-year yield, at a lower than normal targeted rate. This is achieved by continuously purchasing as much of the 10-year bonds as needed to keep the yield at the targeted level. The objective of the YCC, as with all forms of interest rate repression, is to keep debt servicing costs low, which is useful for a government faced with the world’s largest debt-to-gross domestic (GDP) product ratio.

Regardless of whether these unorthodox policies were truly innovative, they certainly caused mission creep and a massive balance sheet expansion at the BoJ. All the QE and YCC activities resulted in the BoJ being not only the country’s central bank but also its largest bond and equity holder. Effectively broadening its mission to include fund management. It was the nation’s largest equity holder with an approximate holding in listed shares equivalent to 7% of total market capitalisation. The central bank was also reportedly a top 10 holder in about half of Japan’s blue-chip listed stocks. As much as the equity stake was through the purchase of exchange-traded funds, the passive buy and hold strategy that this entails has raised concerns about implications for corporate governance at the underlying firms. Not surprisingly, given the mission creep, the BoJ’s balance sheet has expanded to approximate the entire nation’s GDP.

It is easy to see the distortionary effects all these market interventions would have on the domestic economy. The wedge created in the price formation process by some of these distortions give rise to arbitrage opportunities. And the biggest and most lasting arbitrage opportunity has been the yen carry trade. The carry trade involves borrowing yen in Japan at the ridiculously low interest rate and investing in other Organisation for Economic Co-operation and Development countries, effectively earning the interest spread. In essence, this was shorting the yen and going long for other foreign currencies. By far the largest of these yen carry trades was between Tokyo and New York. US Treasuries and stocks are the most favoured assets. As a result, Japan came to be the largest foreign holder of US Treasuries, an estimated US$1.2 trillion (RM4.89 trillion) worth.

So, how effective have these unorthodox policies been? Going by how the Japanese economy has performed thus far and where it currently is, the policies have been ineffective. One cannot rule out that the policy-induced distortions and stunted price discovery processes may have contributed to the highly anaemic growth performance. Further, years of QE, given the monetary expansion and repressed interest rates, will inevitably push the currency towards depreciation, as is the case now. Studies have shown that QE-type policies are really hit or miss with huge probabilities of overshooting, going from deflation to inflation, as is the case now with Japan.

The fact that sustained growth has been elusive, even after nearly two decades of monetary pumping through QE and YCC, speaks volumes about the efficacy of the BoJ’s unorthodox policies. In the process, however, Japan’s government debt has grown to be the world’s highest at approximately 250% of GDP. A stark contrast to where the nation was during the rapid growth years of the 1980s. For comparison, debt to GDP was a mere 42% in 1982.

The BoJ now appears to have worked itself into a corner. Inflation is rising sharply and the yen is at 40-year lows. The most recent June Producer Price Index was 7.1% while the yen-based import price index for the same month rose 29.7%. The years of monetary looseness appear to have overshot both inflation and the currency. The logical way to address the inflation and the depreciating yen is to raise interest rates. However, given Japan’s current position, rate hikes will not only substantially increase the nation’s debt servicing costs but also cause a huge erosion in the value of assets on the BoJ’s balance sheet. Thus, while the potential cost of a rate hike to both the BoJ and the nation is huge, not raising interest rates could stoke further inflation and continued depreciation of the yen. The danger is the potential formation of a feedback loop as the falling yen feeds into rising inflation through imports, particularly of oil and foodstuffs.

More than causing problems domestically, the BoJ’s conundrum risks seriously impacting global financial markets. Any sudden reversal of the yen carry trade could cause problems not just for US Treasuries but also for stocks in the US and other countries. Given the current fragility in the US Treasury market, any reverberation could have a herding effect on US financial markets. Developing nations, long addicted to cheap yen-denominated loans, could suffer too. The fact is volatility in global financial markets could be amplified far beyond Japan.

There are two key lessons for policymakers from the BoJ experience. The first is that the central bank mission must not be allowed to creep. As with all institutions, the incentive for empire building and expanding their spheres of influence would be ever present. They must be held to focus on domestic monetary stability. The second lesson is that monetary policies, being blunt instruments, cannot be relied upon where precision is needed nor to address structural issues. Still, as the BoJ experience shows, there is always the temptation to use monetary tools in as many ways as possible. As the saying goes, when the only tool you have is a hammer, every problem looks like a nail.

Dr Obiyathulla Ismath Bacha is professor of finance at INCEIF University

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